Inflation in the region1—which rose to over 8 percent in August 2008—is expected to remain high through end-2008, before beginning to decline gradually in 2009. For Latin America and the Caribbean, this surge in inflation is the first real on the region’s commitment to low inflation. To asses the challenges of keeping inflation under control, a recent study by IMF staff analyzes two related questions: (1) what are the main determinates of the inflation surge? and (2) how monetary policy has responded so far?.

The study is based on a new dynamic macroeconomic model estimated for the United States, Europe, Japan, and the five inflation targeting countries (IT) for the period through the first quarter in 2008. It finds that the most important factor behind the rise in inflation since 2006 was supply shocks—most likely coming from higher food and fuel prices—that hit when excess demand pressures were building in most of these countries. In fact, these economies were found to have been operating above potential since last year. The study also finds that the moderate slowdown in growth in advanced economies, through the first quarter of 2008 appears to have had only a modest effect on inflation in these five countries through early 2008.

The policy responses in these IT countries were found to have been firmly geared to reduce inflation, which over time should also help build credibility further. Also, monetary policy has been supported by e a strong fiscal position and exchange rate flexibility —and currency appreciation in particular.

Going forward, monetary policy continues to face a challenging environment. In many of the IT countries, headline inflation is still above target, with the economies operating above potential, yet the current global environment is full of uncertainty. It will be important to stand ready to adapt monetary policy as needed to bring headline inflation comfortably within the target range. An important lesson of this recent episode is that, while monetary policy has become more credible since the adoption of IT, there is still room to anchor inflation expectations even more firmly, which would help reduce the persistence of inflation.